October 19, 2017
Market Summary – 3rd Quarter, 2017
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”
~Blaise Pascal, 17th century mathematician and philosopher
Since the inception of capital markets, investors have been searching for the secret sauce – the ultimate key to investment success. Is there one factor that matters above all others as we seek to accumulate wealth? Let’s consider some of the prime possibilities.
Some will say the secret is simply to concentrate investments in stocks. They will point to the long-term record, how $1 invested in stocks since 1802 grew to a value of $1,136,042 by the end of 2016. This outpaced bonds by over 685x, where $1 grew to just $1,6491. The performance of stocks over time is impressive, but the number may mislead people into thinking that simply owning “the market” is the secret to investment success. Not all stocks will perform to that level, and even owning “the market” has its drawbacks. Most notably, when the price that you pay for a stock is too high, your odds of success are greatly diminished.
Does this mean that a selective approach, only buying “cheap” companies, is the answer? No, it is not. The problem is that cheap stocks don’t always represent attractive investment opportunities. Some stocks are cheap for a reason. A prudent investor has to be more discerning, thoroughly scouring the market for those rare stocks that represent solid businesses in a strong position for future prosperity but that are currently misunderstood by the market. These are the kinds of stocks that offer appealing return potential with limited downside risk. These truly unique and great investment opportunities are rare, and we have committed ourselves to uncover them- as elusive as they are.
©Mort Gerberg/The New Yorker Collection/The Cartoon Bank
Attention to identifying true value opportunities in the market CAN make a positive difference for investors. But simply identifying these opportunities is not enough. Investors must have the fortitude to wait for the market to recognize the value of the investment and reward it with a higher price. In the long run, evidence suggests that a patient, selective, prudent value investing approach is the most effective wealth creation strategy. Yet it is important to recognize that value investing is, at times, out of favor. Just as in the Aesop fable of the tortoise and the hare, it is important to remember that while the tortoise ultimately triumphed, it was not always winning the race.
Markets may fluctuate on a seemingly random basis over short-term time periods. For example, in any given 12-month period, most returns are dictated by unpredictable price changes. But by the time a holding period extends to five years, 80% of the total return is generated by the price paid for the investment PLUS growth in the company’s underlying cash flow.2 These are the fundamental tenants of successful investing, and they clearly only matter over a long term time-frame.
Quite simply, the most important secret to investment success is PATIENCE. The tortoise wasn’t in a hurry. He simply stayed true to his nature, focused on his ultimate goal, ignored distractions and ultimately prevailed.
The need for speed? Not here
To put it succinctly, our best advice to investors is borrowed from Pascal. The challenge for most investors is to exhibit patience – and avoid being tempted by immediate gratification or the compulsive need to take action for action’s sake.
We are reminded of the famed Stanford marshmallow test3, where a treat such as a marshmallow is placed before a child who is given a choice – eat it now, or wait for approximately 15 minutes and be rewarded with an additional marshmallow. An important lesson taken from the study was that children who were able to delay gratification in order to earn greater benefits in the future tended to enjoy more successful lives as adults.
Investors are regularly faced with a similar test, particularly in today’s markets. They have instant access to their portfolios through smartphones and computers, providing an up-to-the second read on how their investments are performing. They are bombarded regularly with late-breaking developments with the implication being that this is information upon which they should act. It is not an easy time to sit still and ponder the future glories of delayed gratification.
But have investors actually benefited from the advanced technology and unhindered information flow? The evidence says they have not. For decades, the financial research firm DALBAR has documented how investors trying to outsmart the market with short-term decisions have often made costly decisions. For the 20-year period through the end of 2015, the average stock fund generated an annualized return of 7.7%, which would have resulted in a $1 million investment growing to over $4.4 million over 20 years. By contrast, the average stock fund investor earned only 4.8%, meaning that the same $1 million would have grown to only $2.6 million over that same time period – an opportunity cost of over $1.8 million. So despite all of the information advantages investors would appear to have today, they failed to handle it properly. Prudence gave way to knee-jerk reactions that cost the average investor significant wealth.
The lesson here is critical – successful investing is not about the ability to make a trade at lightning speed and capture a quick buck, because the numbers show that most investors, even many professionals, aren’t good at that. Successful investing has always been about buying good assets at prices below their true value, and waiting patiently for the market to recognize that value.
Patience as a critical investment tool isn’t just about holding on to a good stock, but also in acquiring them in the first place. Truly great investments are a rarity. Uncovering great companies is one thing. Having the patience to wait for the right time to invest in them is something else.
It is not unlike the process wild animals use to hunt for their meals. Lions don’t randomly rampage through the African savannah hoping to snatch a stray gazelle. They learn early in life that such a strategy will leave them hungry. While they take great care to pinpoint their target, it is not the key to claiming their reward. Having the patience to carefully stalk their prey and only strike at the exact right time will result in success. Patience is everything.
Disciplined investors look for great businesses, then wait patiently to make certain that the stock has reached a truly attractive price level before choosing to invest. Once that time comes, investors will move quickly to capitalize on the opportunities. They tend to be rare, but they will emerge from time-to-time for those looking in the right places. Investors must be strong in their convictions because investing in out-of-favor stocks means going against the conventional wisdom of the day.
There are no shortcuts
Being an investor is hard. There are constant distractions, as well as the timeless temptation to forego a patient and prudent approach in favor of easy or get rich quick ploys. But there is no elusive magic bean or miracle tonic that will lead to great wealth. Throughout history, speculators have tried . . . and mostly failed. Consider tulip mania of the 1700s, the Nifty Fifty stock craze of the 1960s, the dot-com bubble of the 2000s, housing in the mid 2000s, and perhaps even index funds and exchange traded products of today. In each of these periods investors/speculators may have enjoyed short term gains, only to be disappointed and begin a new search for the next sure thing, but often with significantly less money. We believe that like most things in life, good things come to those who work relentlessly on developing a craft, persist when times get tough, and exhibit the self-discipline to forego immediate gratification in favor of truly hard-fought and earned rewards.
©Arnie Levin/The New Yorker Collection/The Cartoon Bank
1Jeremy Siegel, Stocks for the Long Run, (McGraw-Hill) 2014 (chart updated 2017).
2James Montier, The Little Book of Behavioral Investing, (Wiley), 2010.
3Mischel, Walter; Ebbesen, Ebbe B.; Raskoff Zeiss, Antonette (1972). “Cognitive and attentional mechanisms in delay of gratification.”. Journal of Personality and Social Psychology.
The Marshmallow Test
In the 1960s, a Stanford professor named Walter Mischel began conducting a series of important psychological studies. The experiment began by bringing each child into a private room, sitting them down in a chair, and placing a marshmallow on the table in front of them.
At this point, the researcher offered a deal to the child.
The researcher told the child that he was going to leave the room and that if the child did not eat the marshmallow while he was away, then they would be rewarded with a second marshmallow. However, if the child decided to eat the first one before the researcher came back, then they would not get a second marshmallow.
So the choice was simple: one treat right now or two treats later. The researcher left the room for 15 minutes.
Image credit: Storyboard Films
As you can imagine, the footage of the children waiting alone in the room was rather entertaining. Some kids jumped up and ate the first marshmallow as soon as the researcher closed the door. Others wiggled and bounced and scooted in their chairs as they tried to restrain themselves, but eventually gave in to temptation a few minutes later. And finally, a few of the children did manage to wait the entire time.
Published in 1972, this popular study became known as The Marshmallow Experiment, but it wasn’t the treat that made it famous. The interesting part came years later.
As the years rolled on and the children grew up, the researchers conducted follow up studies and tracked each child’s progress in a number of areas. What they found was surprising.
The children who were willing to delay gratification and waited to receive the second marshmallow ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills as reported by their parents, and generally better scores in a range of other life measures.
The researchers followed each child for more than 40 years and over and over again, the group who waited patiently for the second marshmallow succeed in whatever capacity they were measuring. In other words, this series of experiments proved that the ability to delay gratification was critical for success in life.
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
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Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
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